EIU global forecast - US-China trade war will damage growth

Since the start of 2018 trade policy has become the biggest risk to The Economist Intelligence Unit's central forecast for global economic growth. We now expect this risk to materialise in the form of a bilateral trade war between the US and China, with negative consequences for global growth. Although the trade dispute between the US and the EU has paused for now, the dispute between the world's two largest economies only shows signs of escalation. It seems likely that the administration of Donald Trump, the US president, will move ahead with the vast majority of tariff increases on a further US$200bn-worth of Chinese imports. As the economic effect of these tariffs, and those already imposed in the trade dispute, increases over the remainder of 2018, we expect the Trump administration to come under increasing pressure to refrain from further tariff increases. This political pressure, combined with the Republicans' loss of the House of Representatives in the November mid-term elections, which is our expectation, will cause the Trump administration to rethink its trade strategy. At the heart of the dispute between China and the US is a disagreement over intellectual property and China's technology transfer practices, although the US trade team is divided on this issue, with Mr Trump also focusing on the US's trade deficit with China. Given this, discussions thus far between the two countries have failed to solve the dispute, and a resolution looks unlikely in the short term. By 2019 this will dampen growth in both economies and act as a drag on growth in the wider global economy. We had already anticipated a slowdown in the global economy in 2019, as political uncertainty and market turbulence is putting a brake on growth in Latin America. As a result of the trade war, we now expect the slowdown in growth to be more pronounced, at 2.8% (2.9% previously).

Growth in the US and China will slow more than expected in 2019

The trade war comes at a challenging time for the Chinese economy. Concerns over the strength of domestic demand have returned, as momentum in both private consumption and investment has weakened. Central to this slowdown is the deleveraging campaign that began in 2016. The effects of tighter monetary policy, corporate deleveraging efforts and a crackdown on shadow financing have become more apparent in the economy this year, having raised the cost and availability of capital for both firms and consumers. The trade war will lessen the focus on deleveraging, with authorities needing to take measures to support growth in the short term. We are likely to see a moderate easing in fiscal policy, such as cuts to taxes and fees, together with an easing of reserve requirements from the People's Bank of China (China's central bank). There is recognition from policymakers, however, that capacity to support the economy will be limited by China's debt profile. On these assumptions, we have revised China's growth in 2019 down to 6.2%, from 6.4% previously. Although we expect growth to be maintained to reach the government's target of doubling real GDP this decade, the trade war has again raised the spectre of China's financial vulnerabilities, which will cloud the economy's outlook for the foreseeable future.

The trade war will also affect the US economy, which has so far had a stellar year in 2018. We have revised up our forecast for real GDP growth in 2018, to 2.8% (from 2.7% previously), to reflect faster than anticipated growth in the second quarter, of 4.1% in annualised terms, driven by rising domestic demand and a temporary surge in exports. The economy continues to receive support from the Trump administration's fiscal policies, as well as the ongoing strength in the labour market. However, the escalating trade dispute with China will start to weigh on growth later in 2018 and into 2019—we now expect growth to slow in 2019 to 2.2% (2.5% previously). The US manufacturing and agricultural sectors, in particular, will be hit by the trade dispute, and rising interest rates will cause private consumption to slow. Growth will continue to slow in 2020, reaching a nadir of 1.3%, as the lingering effects of the trade dispute, higher interest rates and softening corporate balance sheets result in a business-cycle slowdown. A mild recovery will take place in 2021‑22 as these effects unwind, with growth averaging 1.8%.

US protectionism threatens the multilateral system

The Trump administration's protectionist trade strategy has also raised tensions with the US's traditional allies, threatening to upend the multilateral system. Initially, when the US announced import tariffs on steel and aluminium in March, Canada, Mexico and the EU were given exemptions. The exemptions were removed by the Trump administration on June 1st, sparking a round of retaliatory tariffs from these traditional US allies. Reaffirming his transactional approach to US allies, Mr Trump deepened divisions in the G7 on June 8th‑9th when he failed to agree to the joint communiqué in support of a rules-based trading system. Mr Trump's European trip in mid-July further demonstrated his lack of concern for the US alliance system. Despite signing a communiqué in support of the NATO alliance, Mr Trump sharply criticised Germany's imports of Russian gas and publicly berated member countries for their contributions to the NATO budget. Given this approach to traditional US alliance structures, we do not expect the Trump administration's transactional approach to trade to differ greatly towards long-standing US allies. Following the withdrawals from the Paris climate accord, the Iran nuclear deal and the Trans-Pacific Partnership, the outcome of the G7 meeting and related trade tensions with key US allies again demonstrate that Mr Trump's "America First" policies do not align with a multilateral system of global governance.

The rest of the world is adjusting to US protectionism by developing regional trade agreements and diversifying their trade partners. The Comprehensive and Progressive Agreement for Trans-Pacific Partnership (CPTPP) will come into effect in early 2019, after Japan became the second country to ratify the agreement, and additional countries have expressed their interest in joining. We expect more countries to join the CPTPP in the coming years. Japan became a central player in the push to finalise the deal after the US withdrew from the agreement. Further demonstrating the country's commitment to trade liberalisation, Japan signed the world's largest free-trade agreement with the EU this year. The main elements of the deal include the near-elimination of tariffs on Japanese goods entering the EU, but those applied to EU goods by Japan will be reduced in a phased manner. The next stage is for Japan and the EU to ratify the accord. Countries in Latin America, Africa and Asia are also looking to develop regional trade integration. We expect more countries to develop trade ties with new partners, risking the isolation of the US economy and the market share of US exporters.

Global monetary conditions will tighten, but at a slower pace

Heightened international risks will cause some central banks to delay or slow their plans to normalise monetary policy. However, the Federal Reserve (Fed, the US central bank) remains committed to raising interest rates. With US unemployment reaching new lows, but inflation remaining contained, we expect the Fed to continue to raise rates at a steady pace. Reflecting the revised outlook for US growth—stronger this year and weaker next year—we expect a total of four rate rises this year, followed by another three in 2019 as the Fed balances the risks of rising inflation against slowing growth. We expect the Fed to embark on an easing cycle in 2020. Most emerging-market economies should be able to weather this pace of economic tightening, provided that their trading conditions remain favourable. However, investors are on the alert for financial, economic or political weaknesses. The turbulence experienced by Argentina and Turkey in mid‑2018 is a reminder of how difficult it can be for policymakers to regain market confidence where external imbalances are large and macroeconomic policy frameworks fragile. For now, a full-blown emerging-market crisis should be averted, but we expect the number of countries seeing their currencies come under pressure to rise over the next two years. It is likely that we will see periods of volatility as the global trade dispute interacts with the shift away from easy money.

Geopolitical risks foreshadow greater volatility

We also note the economic risks posed by the complex and deepening tensions in the Middle East. Various proxy conflicts between Iran and Saudi Arabia have the potential to further destabilise the region. Mr Trump's decision to withdraw the US from the Iran nuclear deal is another signal that the US is inclined to offer stronger support to its traditional allies in the region, Israel and Saudi Arabia, in the coming years. We expect regional security in the Middle East to deteriorate following the US withdrawal. The move gives hardliners in Iran the upper hand over their moderate counterparts, which is likely to lead to a more confrontational foreign policy. Most worryingly, a proxy conflict between Israel and Iran in southern Syria has a significant chance of escalating.

Heightened geopolitical risk in the Middle East increases the likelihood of volatility in global energy markets. The rebalancing of the oil market pursued by OPEC over the past 18 months means that geopolitical developments now have a more pronounced effect on prices. News of the US's withdrawal from the Iran deal sent prices above US$75/barrel for the first time since 2014. Ismail Kowsari, a senior officer in Iran's Islamic Revolutionary Guards Corps (IRGC), stated on June 4th that Iran would prevent other nations' oil from being exported through the Strait of Hormuz, should its own oil exports be blocked by US sanctions. Although we do not expect Iran to close the Strait of Hormuz, the likelihood of this scenario unfolding will rise as Iran's oil exports decline in 2019‑20, and this risk will continue to be incorporated in crude oil prices.